Is There an Alternative to the Multi-tier Ownership Structure?

John G. Iezzi, CPA, Iezzi Management Group
February 1, 2003

Each year, firms of all size struggle with the perennial question of promoting associates to partner. Invariably, the decision rests in large part on the reluctance of the partner group to admit additional owners who will share in the firm’s income pot. This is an even larger problem if the pot is not growing sufficiently resulting in everyone’s piece of the income stream getting reduced as new owners are added which dilutes the percentage share of everyone else.

One of the alternatives that many firms have used since the mid 1970’s has been the creation of the non-equity partner. This is an individual who is essentially paid as an associate, but gets some status both internally as well as with their peers, and usually has an increase in their overall compensation due to a change in their base compensation as well as participation in some bonus pool.

This position has become very popular over the past several years as attorneys have been searching for “alternative lifestyles”, which in the attorney world translates to fewer hours, fewer administrative and management responsibilities and with it, a compensation schedule that is significantly different from the harder working, more involved equity partner.

The problems with this multi-tier system are twofold: First of all, it creates a position where the firm can “park” all those associates who for whatever reason do not pass muster as a partner, but who no one wants to terminate outright. Secondly, even if the right people are placed in this category, the firm then faces the problem of how long to keep them in this group and establish those criteria required to move them out into a full equity position.

Let me address the latter of these questions first and then discuss how a compensation system can be employed which eliminates the need for the non-equity slot entirely and protects the current equity partners at the same time.

There are several reasons, some already discussed, why firms establish the non-equity partner position.

1. Do not want to share extremely good years with other equity partners and thus dilute the current partners’ share of the profits. This has already been addressed and will be discussed further.

2. Do not want others to share in the decision-making processes of the firm. There are partners who enjoy the power that comes with being an owner and oftentimes are not willing to share that power with others. Again, there is a solution to this, which will be addressed later.

3. Younger partners cannot afford the requisite capital contribution so they are left in the non-equity status until their personal financial situation changes. This can be a problem but can be resolved easily by either having no capital contribution for a period of years after equity partner admission or have the individual borrow the money from the firm’s bank, have the firm guarantee the debt and then have the amounts paid back through payroll deductions.

4. Do not want to fire someone so they are made a non-equity partner. Of the four, this is the worst reason to elevate someone to this status since very soon the firm ends up with a group of highly paid attorneys, none of whom could adequately pass muster to be full owners and who end up preventing the firm from growing at the bottom where new owners are initially created. At some point, the firm needs to bite the bullet and terminate these attorneys. It is better to do it early on so that the individual can find other, more suitable employment rather than later when that employment may be more difficult to find.

One axiom must be kept in mind in any and all deliberations concerning the issue of a multi-tier partnership system: Whether one is elevated to partner is an evaluation question. How they are paid, i.e., as an equity or non-equity partner is a compensation question.

Unfortunately, firms get confused about this and fail to recognize the difference. They end up, as noted earlier, placing people into this category for compensation reasons, even though the requisite criteria for partner has not been fully met.

The criteria to be a partner in most firms is generally the same. Good skills as a lawyer; good management and administrative skills; gets along well with people; good work ethic; good personality traits and communication skills that could lead to business originations; etc. These are the criteria that every partner needs to fulfill to be elevated from the associate ranks. This is the normal evaluation process.

Then comes the question of how that person is to be paid. As a non-equity partner they are paid with some guaranteed amount plus bonus or as an equity partner with some share of the overall profits of the firm based on contribution. This is a compensation question. The two issues should not be confused, else the firm will fall into the pattern noted earlier of admitting less than fully qualified attorneys into partner status.

What then separates the non-equity partner from the equity partner? This can be cast into two criteria:

1. Will have demonstrated through a significant client following, the ability to attract and retain new clients on a continuing basis; or,

2. Will have demonstrated outstanding legal skills that the Firm believes are important to its ability to successfully represent clients in those areas of the law requiring unusual, sophisticated or highly technical legal issues.

In today’s law firm, one either needs to be an outstanding finder (business originator) or outstanding grinder (great legal skills) to achieve a status whereby they can participate fully in the financial success of the firm.

This then leads back to the question of how does a firm move attorneys into the equity ranks without completely diluting the income shares of the current equity owners.

The truth is that if firms can control compensation, which few firms can, there really is not need to have a multi-layer structure. By limiting the compensation of the new equity partners, the firm can avoid the dilutive effect of new owners as it relates to the diminishing of the profits left for the other owners.

This can be accomplished by doing two things: First of all is to create another classification called Senior Equity Partner (Shareholder, etc.) which distinguishes the more senior equity partners from the other more junior equity partners. Secondly, is to establish an income tiering system whereby the total income of the firm is divided into three tiers. The first tier is for distribution to all equity partners. This is normally some percentage of the average profits over the last three to five years. Above that to some number is the second tier shared only by the owners designated as senior equity partners. The third tier, representing the truly bonanza piece of the firm’s annual profits, can be shared by anyone or everyone as determined by vote of the Equity Partners. It could be allocated on the basis of income percentages, performance, per capita, etc.

In addition, by tying ownership percentages to income percentages, the more senior equity owners, with the largest overall income shares would still retain a greater share of the decision-making power, which they may be reluctant to share with those more junior to themselves. Thus, another reason for the non-equity group goes away.

This process permits the firm to control the new owner’s compensation while at the same time allowing them to earn significantly more than they did as associates. It permits them to reap the benefit of becoming equity partners in the first place and through some level of capital contribution, obtain the right to participate in the firm’s overall economic successes.